Firat Ünlü's  Instablog

Sino-US relations are becoming ever more important and for investors it is critical to understand the political factors that drive China as well as basic economic fundamentals. While I will provide a review of Chinese foreign exchange holdings and past trade patterns I have to emphasize that for as long as the Taiwan issue remains unresolved both countries could find themselves in a conflict situation within days. Next to providing a stable environment for economic growth future reunification with Taiwan is one of the two main pillars of regime legitimacy. 

"Now many countries are saying that China is good and hope that China will emerge, but honestly we are still a developing country. Don't over estimate the fact that we have almost 2 trillion dollar in our foreign exchange reserve. If you take that amount and divide it by 1.3 billion people, how much per head is that? Therefore, we truly need to conduct our own affairs well."
-Hu Jintao in 2009 

As a result of large current-account surpluses some nations have been able to build up impressive foreign exchange reserves with China having surpassed Japan sometime in 2008. Brad Setser who works on the Council on Foreign Relations (CFR) has provided a fine analysis of China’s foreign asset holdings on his blog, in of the more recent entries he sees China approach a staggering 2.5 trillion in foreign-asset holdings. 

When looking at this graph we have take into account the enormous rise after 2003 when foreign exchange holdings were at US$ 500 billion. They have increased five-fold since then. This means that China has domestic wealth-creation facilities and the ability, should e.g. US-debt be defaulted on, to quickly make up any losses. 

Setser came to US$ 2.5 trillion by adding $1.946 trillion in formal reserves. $252 billion in portfolio debt and a further roughly $250 billion for bank’s dollar holdings and the assets of the China Investment Corporation (CIC)
How has China managed to build up such a large amount of foreign-asset-holdings? That issue is of much debate, leading to many heated sessions in the US Congress with some people accusing China of being a ‘currency manipulator’. 
China is not the only goods-exporting nation that is running up a substantial surplus, Germany which is part of the Eurozone boasts a similar current- account surplus and can hardly be accused of being a currency manipulator. 

A paper by the Congressional Research Service (CRS) summed up the accusations that China intentionally holds down the value of her currency thus making American exports to China more expensive leading to a loss in manufacturing jobs and a substantial trade deficit.
From 1994 to 2005 China pegged the yuan to the US$ at an exchange rate of 8.28. It was considered to be close to market value at the time.  
However in 2005 policy switched and it was decided to let the yuan float against a basket of currencies. Ever since the exchange rate has moved to 6.83. Government is still intervening though and the shift is happening at a lesser pace than market forces would suggest. Despite that appreciation some still argue that the yuan is undervalued by about 15-40%. A recent study by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii arrived at the conclusion that the exchange had been undervalued by 10 % in 2006. Considering the yuan moved up by 18% since December 2007 alone we may conclude that as of now the yuan is close to where it should were it fully under market forces.  

China is not the only country to massively increase dollar-holdings, other East Asian nations followed suit. Why were they doing this? After all it is ironic that some of the world’s poorest nations (by GDP/Capita) were pouring trillions of money into one of the richest, United States of America. Typically one would assume that those nations would be using their savings and CA surpluses within their domestic economy given the needs for infrastructure and basic social welfare. 
Following the Asian crisis in 1997 many countries found their currencies under speculative attack and were only able to receive IMF credit lines by following austerity measures the US itself would not have imposed upon itself. The lesson those countries and an enraged public took from it was to build up foreign exchange reserves in order to be able to weather the next storm without IMF help (e.g. the IMF forced the countries to increase interest rates, that choke off economic growth). As a result the IMF’s reputation has suffered a lot of damage in East Asia with most governments very hesitant to approach it in times of crisis.

It was only in the 1970’s that the Western World moved to floating exchange rates, economic policy in China is driven by the desire to achieve both high growth rates but also stability, the Communist Party could politically not afford a serious downturn and is thus following a very cautious line. 
Factoring in various problems such as the instability market forces (maybe even distrust of market forces within the CCP), the relatively short time floating exchange rates have been in existence and how quick ‘hot-money’ in-and-outflows can cause destabilization it is only understable that China only gradually eases restrictions on capital movement and yuan convertibility. 

However as noted above, on a per-capita basis China’s foreign exchange reserves aren’t that impressive and there is a focus to concentrate on solving the vast array of problems at home. Nonetheless China is engaging in the world at a rising speed and has found its influence already increased. 
 
Buying Influence

A large part of China’s Foreign exchange reserves is invested in US-Treasuries and US Agency debt. A noticeable shift towards short-term Treasury bills has been happening most recently and China has been aggressively snapping up deals to secure natural resource supply.
As China holds such an enormous pile of foreign exchange reserves it has given rise to speculation that China might use them in order to gain influence by giving out ‘soft-loans’ or helping out in other ways.
It came as no small surprise when Pakistan’s president Asif Ali Zardaria approached Beijing in 2008 for some hundreds of millions in emergency aid. Geopolitically that move makes sense as India, feeling threatened by China’s string of pearls policy, and America have been moving ever closer. It has been reported that America and India are in negotiations to develop an Indian missile shield. 
China is already strengthening ties in the region with Burma’s regime and is still well regarded in Thailand for its help after the Asian crisis. Not to mention the fear and anger stoked by China’s involvement in Sri Lanka’s by building a port in the country's southeast at Hambantota; after the United States dropped aid because of human rights issues China became the biggest donor and equips Sri Lanka with military hardware. 
China is further engaging in the Mekong region building ties through the Greater Mekong Subregion Programme for Economic Cooperation.  
From personal experience in the region Chinese influence, especially in Cambodia and Vietnam to a smaller degree, became evident after seeing how ethnic Chinese dominated business.

The Bond Market


While China’s been quickly adding to its holdings of treasuries Japan has been keeping them about constant which means that it did not engage in buying treasuries in a meaningful way in the past few years and looks set to continue in that role. The oil exporters hold fewer than might be thought given that they receive billions daily for their resources (US$ 200bn). The UK has holdings in the range of about US$ 130bn. Holdings of China, Taiwan, Hong Kong and Singapore put together were close to one trillion (US$ 962bn)
It is important to note that whilst the other players aren’t involved with similar stakes there are more than a dozen nations, most of them geopolitically important, also involved in the Treasury market. Any quick move out of Treasuries by China would lead to massive losses for all the parties concerned which is why despite the talk of China using the ‘nuclear option’ of selling large amounts of those bonds it would be political harakiri leading to worse relations with key players such as the oil exporting nations, Brazil, Singapore and Turkey.

Foreign Assets & Trade 




The US Share of China’s Portfolio has remained just about constant since 2000, dipping slightly higher over time.  





The majority of China’s US holdings is invested in Treasury bonds, the second largest group being agency bonds. However China has been leaving the agency bond market (mostly Fanny & Freddy) over uncertainty about their financial soundness. China further holds each $100bn in corporate bonds and equities.


Chinese assets have grown steadily over time, reserve growth skyrocketed in 2007 and 2008 at the height of the consumption bubble. After a sharp downfall in trade reserve growth currently it is at the level of 2005. 

Chinese purchases of treasuries and agencies have provided about half of the financing the United States stemming from central banks. 
While the black line shows the American trade deficit the green line depicts the purchases of central banks, with red representing Chinese purchases. Japan hardly increased its purchases as can be seen by the dark blue line which hardly moved above the zero line.

Trade Patterns

Trade stands now at more than US$ 400bn, quadrupling in size over less than a decade. The trade deficit was at a staggering 266.3bn in 2008. Chinese exports have for years increased at over 20%.
US exports had similar growth rates but started at a much lower basis. 
China’s electrical machinery & equipment exports to the United States were larger than all American exports to China put together ($80.3 bn against $71.5. bn).


China increased exports to the world by a factor of seven within a decade, imports haven’t risen at the same pace however and thus China’s been able to record a surplus of almost $300bn in 2008. Trade has been highest with the United States followed by the East Asian neighbours and Germany.
Trade with other nations has been far more balanced, The United States is the biggest export destination but only ranks fourth in terms of imports, behind Taiwan. Germany has a fairly balanced trade relationship, Japan and South Korea even hold surpluses against China. The United States thus remains one of the most important countries for China, about one fourth of its exports make its way to the ports of America. As the yuan dollar exchange rate is on a ‘managed float’ China needs to buy those dollars generated by the trade surplus in order to keep the exchange rate stable. To gain interest on these dollars China invests them back in the United States.



The American Budget

“Be Nice to the Countries That Lend You Money”
- Gao Xiqing 

The forecast by the Congressional Budget Office (CBO) projects record fiscal deficits all the way through 2020. Most of the deficit is structural, one-off programmes like the stimulus package and TARP don’t make up for the huge gap.

Before heading to the current bond market remember the problems continental Europe faces. Milton Friedman predicted that the Eurozone would not survive its first economic crisis. The problems confronting Britain - this year alone at least 12% of a budget deficit, not to mention the insane growth in credit and asset price inflation. Many people will be asking themselves if being able to vote every couple of years if worth the political shenanigans, what's the point in voting if your mortgage payments go through the roof because of policy-induced price hikes?
Now compare the relative macroeconomic stability China enjoys amidst all that data coming from the Western Word. A side effect of political turmoil in the West would be a strengthening of regime legitimacy in China which would hurt the democratic movement for decades to come. The Communist Party will thus do its utmost to prevent any severe downturn which is why we shouldn't expect monetary tightening anytime soon.

Considering China’s vast population GDP/capita will remain low for decades. However, wealth is unequally distributed within China. What is often forgotten is that a flight to Albania or Sweden is about equally long from Frankfurt, Europe itself does have pockets of poor people. 
China’s huge population makes it impossible for hundreds of millions to find work in productive jobs (some companies ‘dumb down’ processes as Chinese labour is cheaper than machines in some cases), thus their wages are low , thus they ‘drag down’ per capita figures. Still, hundreds of millions will find decent work that enables them to be just as productive as a Westerner, the only thing that is keeping their pay low is the currency they are being paid in. And that moves us to the bond market.

Deflation or inflation?

One of the most critical debate in today’s world is whether we're going to face deflation or inflation.  Both sides have powerful arguments on their side setting multi-billion bets each way. 
Inflationistas point out to the large increase in money supply and quantitative easing, deflationistas to the huge wealth and credit destruction as well as excess deposit reserves (i.e. the printed money isn’t given out in loans).  

Not only is there thus dollar-risk, there is also a risk of losing money on bonds as interest rates have to rise in order to get enough investors to part with their capital. Within China there has been apprehension over the security of its bonds and there is increasing pressure on the US to assure China. “It will be helpful if Geithner can show us some arithmetic” was said by Yu Yongding, former Chinese Central bank advisor, when Treasury Secretary Geithner came to China. Furthermore 17 of 23 Chinese economists having been asked prior to Geithner’s arrival in June 2009 considered holdings of Treasuries a “great risk” for the nation’s economy. 
Most embarrassingly, when claiming that Chinese assets were very safe during a talk at Peking University his answer drew laughter from the student audience. 
The US needs to issue some 2 trillion in debt this year alone (the forecasts had been too optimistic again). Every second dollar that is spent is borrowed. 

As is visible from the CBOs forecast that situation will only slightly ease. However the question remains as to how the deficits are going to be financed. The FED has been trying to absorb some of the debt and keep yields low by engaging in quantitative easing, basically monetizing the debt. The programme runs at 300 billion. 
As noted above low yields are absolutely necessary as the 30-year mortgage rate and thus housing prices are linked to the ten-year bond. With falling house prices banks will not be able to repair their balance sheets and many people find themselves ‘underwater’ on their mortgage. However, there is a conundrum in that government deficits to the tune of two trillion US$ inevitably pushes yields higher. The FED cannot keep on monetizing the debt as this is stoking inflationary fear among investors and would cause them to sell their bonds.  
Further quantitative easing causes investors to sell their bonds to the FED (high bid-to-cover ratios) as the FED must overpay in order to keep rates low. 
This is harming the long-end of the curve as we can already witness a steep-yield curve. Many flee towards the short-end. In fact quantitative easing can cause mistrust since the market is not allowed to work on its own and there’s deliberate manipulation.  
Recently a shift from long-term bonds to short-term bills has been visible. China is moving towards the shorter end for now and possibly trying to unwind as much long-term treasuries as possible, due to being such a substantial holder of treasuries any rash sell-off would lead to massive losses (remember also all the other players with Treasury holdings) on the remaining bonds. Thus China has to gradually ease out of the bond market. They are still earning money from their trade surplus and may decide to invest it in natural resources or keep it simply in cash, in such times many investors value return of money higher than return on money.
The Announcement of QE initially moved rates lower however they’ve been creeping back up again to prior levels. 
There is nothing the FED can to about rising rates as the market is too huge to be controlled (300bn US$ of QE against trillions in debt issuance). Any increase of QE would spark fears of inflation. Investors would be leaving the market as they’d assume debt would be monetized, with fewer investors rates would increase. As a result QE would be self-defeating. China could help get rates lower by showing signs of trust and making commitments in the market.

Commodities & Other Alternatives 

China is making moves into the commodities market and has been been buying farmland in Cambodia and Africa to secure food supply and combat rising world market prices. 
China owns surprisingly little gold. Its reserves have more doubled over the past five years but China is still only the fifth biggest holder with 1,054 tons. The US is the biggest one with 8,133 tons followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons). 
To put those numbers into perspective the International Monetary Fund (IMF) holds 3,217 tons of gold which were valued at US$ 94.8 billion as of March 31, 2009. 
From that we can calculate that America’s gold reserves only cover a fraction of Chinese Treasury holdings. In comparison to other nations China’s gold holdings only account for 1.6 percent of its reserves. 
Even though the IMF will be selling some if its gold holdings the gold market is not big enough to serve as sole source of diversification for China.  

After the collapse of commodity prices China went on a shopping and built up large inventories in items such as iron ore, aluminum, copper, nickel, tin, zinc and soybeans. That increase in prices helped natural resource exporting nations such as Australia. Nonetheless a deal between Chinalco and Rio Tinto fell through amidst speculation that the decision to walk away from the $19.5 billion deal was politically motivated.  
Ironically it was exactly the increase in Chinese spending on commodities that led to dissatisfaction among Rio Tinto shareholders since prices recovered from their low at the time of the offer. 

China is such a big participant that any move it makes immediately changes the market price. No single market is big enough for China to significantly diversify into unless it doesn’t mind paying over the odds.
One option that hasn’t been looked into is to stay in cash as during a deflation the real value of cash rises. That way they would forgoe any interest payment but would have the safety of not having to unwind an asset at a possible loss.

In summary, whether we like it or not, economic policy in the Western World is direcly playing into the CCP's hands. China has been handing out credit as if it were going out of fashion for both political and economic reasons and state banks will surely incur losses on them but domestic stability trumps economic viability.

Sources:
Brad Setser, China’s $1.5 Trillion Bet. Council on Foreign Relations (2009)
www.cfr.org/content/publications/attachm...

www.uschina.org/statistics/tradetable.html

perotcharts.com/category/challenges/budg.../
 
Disclosure: No positions

"It's too early to tell"
-Zhou Enlai, when asked about the impact of the French Revolution

This paper started out by claiming that past economic growth in the West and other areas of the world had been based on the mirage of credit. Debt levels have constantly risen and we are now at a situation where the American consumer, who for so long has been engaged in buying other countries’ goods, services and natural resources is tapped out. “Peak Credit” has arrived with its twin “Peak Earnings”.
China has been one of the main beneficiaries from the spending bubble, profiting from being able to build up an industrial base and employ its citizen in wealth-generating industries such as manufacturing. China may still lack companies at the very high-end but that seems to be more a matter of time than anything.
A couple of years ago Samsung wasn’t where it is today and Japanese cars were ridiculed when they first arrived in America.
China is gradually moving up the value-added-chain and it will be Chinese people who will be studying at reformed universities, Chinese people that will be treated at newly-built hospitals and Chinese people that will be working in newly-constructed skyscrapers. Globalization has moved the world closer together than anytime before, productivity is going to define wages, past barriers that were preventing the Chinese from competing have fallen.

It would be foolish to assume that the only area were competition will be felt is going to be at the low-cost sector, already hundreds of thousands engineers graduate from Chinese universities. Once their quality is improved someone who is graduating now from a prestigious university in the West may find himself losing his job to one of those them - just when he is paying off a mortgage and raising a family.
Western governments are already running large deficits. What happens once the baby boomers retire is guesswork. Even if governments default on current debts or try to ‘inflate them away’ they will still have to find a way of paying for those health-care and social benefits.
We in the Western world need have a long and hard look at ourselves and think about how we got into this mess. The financial crisis is only overshadowing the structural crisis. That’s why we have to borrow all that money to keep up the living standard. The bond market is showing signs of indigestion and quantitative easing, which means printing money is no solution. The jobs from the FIRE-economy are gone for good and a new source for jobs is yet to appear. Unemployment is rising rapidly but even if there was significant innovation in areas like green-tech it stands to be seen where it would create jobs. Manufacturing-based jobs moved to Asia for competitive reasons, new ones created in new areas would most likely follow that pattern.
Unless genuine wealth-creation comes back to the Western world living standards will decline. Credit is only a temporary means to cover up the economic reality and due to its exponential nature any credit line taken today rises ever higher as solutions are hard to come by.
The biggest fear and risk in the Western world could ironically enough turn out to be living in a democracy since voters show surprisingly little sign of protest over spending billions and billions on banks. But once entitlement spending is cut that along with politicians who are losing credibility could turn out to lit the fire.

China is by no means perfect, it has enough domestic problems of its own.
However if it manages to stay stable that alone could see it surpass the United States by default.
China has the capital to upgrade its infrastructure and improve benefit spending. Beijings’s airport is one of the world’s finest, metro networks are rapidly expanded throughout China as are roads and railway lines. Since its infrastructure in many places is old and inadequate investment in this area will pay huge dividends.
Whilst some parts of its economy suffer now from relatively low spending on consumption the huge backlog of savings can more than make up for that in the future and become a useful tool to restart the economy. Any money that is not spent now will be be available in the future and thanks to interest that amount will have grown substantially. Housing is an important aspect to most Chinese and even though mortgage payments take away money from consumption it helps form capital for the future. Huge foreign-exchange reserves, capital formation and investment spending. The Chinese balance sheet looks more than just healthy.
Historically power has always shifted to where the money is.
The money is in East Asia now.

“Be Nice to the Countries That Lend You Money”
- Gao Xiqing

 The forecast by the Congressional Budget Office (CBO) projects record fiscal deficits all the way through 2020. Most of the deficit is structural, one-off programmes like the stimulus package and TARP don’t make up for the huge gap.

Before heading to the current bond market remember the problems continental Europe faces. Milton Friedman predicted that the Eurozone would not survive its first economic crisis. The problems confronting Britain (this year alone at least 12% of a budget deficit), not to mention the insane growth in credit and asset price inflation. Now compare the macroeconomic stability China enjoys amidst all that data. China could very well be heading for supremacy much earlier than assumed (typically thought to happen sometime between 2030 and 2050), not because of its own strength, but because of nations’ weakness, China would then sit atop by default.

Therefore the skillful leader subdues the enemy's troops without any fighting; he captures their cities without laying siege to them; he overthrows their kingdom without lengthy operations in the field. Sun Tzu, The Art of War. 

This doesn’t necessarily entail that China had a ‘grand plan’ to achieve world-dominance, far from it. The focus has always been on making sure Taiwan doesn’t become independent. Solving domestic problems means making sure that its own people enjoy some sort well-being, termed xiaokang. 
Chinese supremacy does not necessarily entail that overall Chinese people enjoy a higher standard of living than Westerners. All it means is that their country would enjoy economic stability in a world filled with turmoil aside ‘islands of prosperity’ such as Germany. Considering China’s vast population GDP/capita will remain low for decades. However, wealth is unequally distributed within China. What is often forgotten is that a flight to Albania or Sweden is about equally long from Frankfurt, Europe itself does have pockets of poor people. 
China’s huge population makes it impossible for hundreds of millions to find work in productive jobs (some companies ‘dumb down’ processes as Chinese labour is cheaper than machines in some cases), thus their wages are low , thus they ‘drag down’ per capita figures. Still, hundreds of millions will find decent work that enables them to be just as productive as a Westerner, the only thing that is keeping their pay low is the currency they are being paid in. And that moves us to the bond market.

Deflation or inflation?

Before we talk about China’s dollar-denominated holdings, most important among them US Treasury bonds, we need to have a look at the most critical debate in today’s world. Are we going to face deflation or inflation? 
Both sides have powerful arguments on their side setting multi-billion bets each way. 
Inflationistas pointing out to the large increase in money supply and quantitative easing, deflationistas to the huge wealth and credit destruction as well as excess deposit reserves (i.e. the printed money isn’t given out in loans).  

Not only is there thus dollar-risk, there is also a risk of losing money on bonds as interest rates have to rise in order to get enough investors to part with their capital. Within China there has been apprehension over the security of its bonds and there is increasing pressure on the US to assure China. “It will be helpful if Geithner can show us some arithmetic” was said by Yu Yongding, former Chinese Central bank advisor, when Treasury Secretary Geithner came to China. Furthermore 17 of 23 Chinese economists having been asked prior to Geithner’s arrival in June 2009 considered holdings of Treasuries a “great risk” for the nation’s economy. 
Most embarrassingly, when claiming that Chinese assets were very safe during a talk at Peking University his answer drew laughter from the student audience. 
The US needs to issue some 2 trillion in debt this year alone (the forecasts had been too optimistic again). Every second dollar that is spent is borrowed. 

As is visible from the CBOs forecast that situation will only slightly ease. However the question remains as to how the deficits are going to be financed. The FED has been trying to absorb some of the debt and keep yields low by engaging in quantitative easing, basically monetizing the debt. The programme runs at 300 billion. 
As noted above low yields are absolutely necessary as the 30-year mortgage rate and thus housing prices are linked to the ten-year bond. With falling house prices banks will not be able to repair their balance sheets and many people find themselves ‘underwater’ on their mortgage. However, there is a conundrum in that government deficits to the tune of two trillion US$ inevitably pushes yields higher. The FED cannot keep on monetizing the debt as this is stoking inflationary fear among investors and would cause them to sell their bonds.  
Further quantitative easing causes investors to sell their bonds to the FED (high bid-to-cover ratios) as the FED must overpay in order to keep rates low. 
This is harming the long-end of the curve as we can already witness a steep-yield curve. Many flee towards the short-end. In fact quantitative easing can cause mistrust since the market is not allowed to work on its own and there’s deliberate manipulation.  
In the past weeks a shift from long-term bonds to short-term bills has been visible. China is moving towards the shorter end for now and possibly trying to unwind as much treasuries as possible, due to being such a substantial holder of treasuries any rash sell-off would lead to massive losses (remember also all the other players with Treasury holdings) on the remaining bonds. Thus China has to gradually ease out of the bond market. They are still earning money from their trade surplus and may decide to invest it in natural resources or keep it simply in cash, in such times many investors value return of money higher than return on money.
The Announcement of QE initially moved rates lower however they’ve been creeping back up again to prior levels. 
There is nothing the FED can to about rising rates as the market is too huge to be controlled (300bn US$ of QE against trillions in debt issuance). Any increase of QE would spark fears of inflation. Investors would be leaving the market as they’d assume debt would be monetized, with fewer investors rates would increase. As a result QE would be self-defeating. China could help get rates lower by showing signs of trust and making commitments in the market. But as noted above it appears that China is in fact moving out of the bond market.
In Europe Axel Weber has been defending the line of the Bundesbank which has been a proponent of a strong currency against other nations who’d prefer a line closer to that of the Bank of England which itself is running a QE programme in the region of £150bn. Angela Merkel, Chancellor of Germany, recently voiced her skepticism towards the actions of the FED and Bank of England (BoE).  

The actions of China are viewed with great interest and even mainstream media outlets such as The Glenn Beck Show on Fox News have provided coverage on the topic insinuating that China does now old the upper hand in Sino-US relations through its foreign exchange reserves. 

Commodities & Other Alternatives 

China is making moves into the commodities market and has been been buying farmland in Cambodia and Africa to secure food supply and combat rising world market prices. 
China owns surprisingly little gold. Its reserves have more doubled over the past five years but China is still only the fifth biggest holder with 1,054 tons. The US is the biggest one with 8,133 tons followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons). 
To put those numbers into perspective the International Monetary Fund (IMF) holds 3,217 tons of gold which were valued at US$ 94.8 billion as of March 31, 2009. 
From that we can calculate that America’s gold reserves only cover a fraction of Chinese Treasury holdings. In comparison to other nations China’s gold holdings only account for 1.6 percent of its reserves. 
Even though the IMF will be selling some if its gold holdings the gold market is not big enough to serve as sole source of diversification for China.  

In the past few months after the collapse of commodity prices China went on a shopping and built up large inventories in items such as iron ore, aluminum, copper, nickel, tin, zinc and soybeans. That increase in prices helped natural resource exporting nations such as Australia. Nonetheless a deal between Chinalco and Rio Tinto fell through amidst speculation that the decision to walk away from the $19.5 billion deal was politically motivated.  
Ironically it was exactly the increase in Chinese spending on commodities that led to dissatisfaction among Rio Tinto shareholders since prices recovered from their low at the time of the offer. 

China is such a big participant that any move it makes immediately changes the market price. No single market is big enough for China to significantly diversify into unless it doesn’t mind paying over the odds.
One option that hasn’t been looked into is to stay in cash as during a deflation the real value of cash rises. That way they would forgoe any interest payment but would have the safety of not having to unwind an asset at a possible loss.

Chart from perotcharts.com/category/challenges/budg.../

While China’s been quickly adding to its holdings of treasuries Japan has been keeping them about constant which means that it did not engage in buying treasuries in a meaningful way in the past few years and looks set to continue in that role. The oil exporters hold fewer than might be thought given that they receive billions daily for their resources (US$ 200bn). The UK has holdings in the range of about US$ 130bn. Holdings of China, Taiwan, Hong Kong and Singapore put together were close to one trillion (US$ 962bn)
It is important to note that whilst the other players aren’t involved with similar stakes there are more than a dozen nations, most of them geopolitically important, also involved in the Treasury market. Any quick move out of Treasuries by China would lead to massive losses for all the parties concerned which is why despite the talk of China using the ‘nuclear option’ of selling large amounts of those bonds it would be political harakiri leading to worse relations with key players such as the oil exporting nations, Brazil, Singapore and Turkey. In 1956 during the Suez Canal Crisis America used that precise threat of ‘dumping’ British bonds in order to force Britain and France to pull out their troops from Egypt.  

Foreign Assets & Trade





The US Share of China’s Portfolio has remained just about constant since 2000, dipping slightly higher over time.  








The majority of China’s US holdings is
invested in Treasury bonds, the second largest group being agency bonds. However China has been leaving the agency bond market (mostly Fanny & Freddy) over uncertainty about their financial soundness. China further holds each 100bn in corporate bonds and equities.


Chinese assets have grown steadily over time, reserve growth skyrocketed in 2007 and 2008 at the height of the consumption bubble. After a sharp downfall in trade reserve growth currently it is at the level of 2005.




Chinese purchases of treasuries and agencies have provided about half of the financing the United States stemming from central banks.
While the black line shows the American trade deficit the green line depicts the purchases of central banks, with red representing Chinese purchases. Japan hardly increased its purchases as can be seen by the dark blue line which hardly moved above the zero line.



Trade now stands at more than US$ 400bn, quadrupling in size over less than a decade.
The trade deficit is at a staggering 266.3bn in 2008. Chinese exports have for years increased at over 20%.
US exports had similar growth rates but started at a much lower basis.


China’s electrical machinery & equipment exports to the United States were larger than all American exports to China put together (80.3 bn against 71.5. bn).
Chinese toy, apparel and furniture exports to the US put together only reach a volume of about 70bn which puts the lobbying efforts coming from those groups for trade restrictions into a different perspective.











China increased exports to the world by a factor of seven within a decade, imports haven’t risen at the same pace however and thus China’s been able to record a surplus of almost 300bn in 2008.

Trade has been highest with the United States followed by the East Asian neighbours and Germany.

Trade with other nations has been far more balanced, The United States is the biggest export destination but only ranks fourth in terms of imports, behind Taiwan.
Germany has a fairly balanced trade relationship, Japan and South Korea even hold surpluses against China. The United States thus remains one of the most important countries for China, about one fourth of its exports make its way to the ports of America. As the yuan dollar exchange rate is on a ‘managed float’ China needs to buy those dollars generated by the trade surplus in order to keep the exchange rate stable. To gain interest on these dollars China invests them back in the United States.



First table: author
All graphs taken from:  Brad Setser, China’s $1.5 Trillion Bet. Council on Foreign Relations (2009) www.cfr.org/content/publications/attachm...
All tables from: www.uschina.org/statistics/tradetable.html



 

"Now many countries are saying that China is good and hope that China will emerge, but honestly we are still a developing country. Don't over estimate the fact that we have almost 2 trillion dollar in our foreign exchange reserve. If you take that amount and divide it by 1.3 billion people, how much per head is that? Therefore, we truly need to conduct our own affairs well."
-Hu Jintao in 2009

 
As a result of large current-account surpluses some nations have been able to build up impressive foreign exchange reserves with China having surpassed Japan sometime in 2008. Brad Setser who works on the Council on Foreign Relations (CFR) has provided a fine analysis of China’s foreign asset holdings on his blog, in of the more recent entries he sees China approach a staggering 2.5 trillion in foreign-asset holdings. 

When looking at this graph we have take into account the enormous rise after 2003 when foreign exchange holdings were at US$ 500 billion. They have increased five-fold since then. This means that China has domestic wealth-creation facilities and the ability, should e.g. US-debt be defaulted on, to quickly make up any losses.

Setser came to US$ 2.5 trillion by adding $1.946 trillion in formal reserves. $252 billion in portfolio debt and a further roughly $250 billion for bank’s dollar holdings and the assets of the China Investment Corporation (CIC)
How has China managed to build up such a large amount of foreign-asset-holdings? That issue is of much debate, leading to many heated sessions in the US Congress.
Some people accuse China of being a ‘currency manipulator’. 
As can be seen above China is not the only goods-exporting nation that is running up a substantial surplus, Germany which is part of the Eurozone boasts a similar current- account surplus and can hardly be accused of being a currency manipulator. 

A paper by the Congressional Research Service (CRS) summed up the accusations that China intentionally holds down the value of her currency thus making American exports to China more expensive leading to a loss in manufacturing jobs and a substantial trade deficit.
From 1994 to 2005 China pegged the yuan to the US$ at an exchange rate of 8.28. It was considered to be close to market value at the time.  
However in 2005 policy switched and it was decided to let the yuan float against a basket of currencies. Ever since the exchange rate has moved to 6.83. Government is still intervening though and the shift is happening at a lesser pace than market forces would suggest. Despite that appreciation some still argue that the yuan is undervalued by about 15-40%. A recent study by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii arrived at the conclusion that the exchange had been undervalued by 10 % in 2006. Considering the yuan moved up by 18% since December 2007 alone we may conclude that as of now the yuan is close to where it should were it fully under market forces.  

China is not the only country to massively increase dollar-holdings, other East Asian nations followed suit. Why were they doing this? After all it is ironic that some of the world’s poorest nations (by GDP/Capita) were pouring trillions of money into one of the richest, United States of America. Typically one would assume that those nations would be using their savings and CA surpluses within their domestic economy given the needs for infrastructure and basic social welfare. 
 Following the Asian crisis in 1997 many countries found their currencies under speculative attack and were only able to receive IMF credit lines by following austerity measures the US itself would not have imposed upon itself. The lesson those countries and an enraged public took from it was to build up foreign exchange reserves in order to be able to weather the next storm without IMF help (e.g. the IMF forced the countries to increase interest rates, that choke off economic growth). As a result the IMF’s reputation has suffered a lot of damage in East Asia with most governments very hesitant to approach it in times of crisis. Today the emphasis is no longer just on the GDP/Debt ratio in emerging markets but also on the short-term debt from firms and financial institutions. One measure of financial risk is short-term debt in relation to foreign exchange reserves.
According to the Economist China was ranking first in an overall risk rating that included short-term debt/reserves, banks’ loan/deposit ratio and current-account balance. 
It was only in the 1970’s that the Western World moved to floating exchange rates, economic policy in China is driven by the desire to achieve both high growth rates but also stability, the Communist Party could politically not afford a serious downturn and is thus following a very cautious line. 
Factoring in various problems such as the instability market forces (most foreign exchange transactions are solely based on speculation), the relatively short time floating exchange rates have been in existence and how quick ‘hot-money’ in-and-outflows can cause destabilization it is only understable that China only gradually eases restrictions on capital movement and yuan convertibility. 
In fact Robert Mundell, Nobel prize winner 1999 in Economics, described the idea of floating exchange rates as "the worst idea proposed in the 20th century". 
Free marketeers argue that supply and demand for goods and services move the currencies into an equilibrium, however as noted above in today’s world the foreign exchange market is only in tiny parts driven by the workings of supply and demand for goods and services. 
 
Buying Influence

A large part of China’s Foreign exchange reserves is invested in US-Treasuries and US Agency debt. A noticeable shift towards short-term Treasury bills has been happening most recently and China has been aggressively snapping up deals to secure natural resource supply. A closer look at the US-Treasury market, the US budget and China’s investment options follows later.
As China holds such an enormous pile of foreign exchange reserves it has given rise to speculation that China might use them in order to gain influence by giving out ‘soft-loans’ or helping out in other ways. Russia’s US$ 4 billion loan to Iceland met suspicion in Washington and Brussels, especially given that Iceland is a NATO member. 
It came as no small surprise when Pakistan’s president Asif Ali Zardaria approached Beijing in 2008 for some hundreds of millions in emergency aid.  
Geopolitically that move makes sense as India, feeling threatened by China’s string of pearls policy, and America have been moving ever closer. It has been reported that America and India are in negotiations to develop an Indian missile shield. 
China is already strengthening ties in the region with Burma’s regime and is still well regarded in Thailand for its help after the Asian crisis. Not to mention the fear and anger stoked by China’s involvement in Sri Lanka’s by building a port in the country's southeast at Hambantota; after the United States dropped aid because of human rights issues China became the biggest donor and equips Sri Lanka with military hardware. 
China is further engaging in the Mekong region building ties through the Greater Mekong Subregion Programme for Economic Cooperation.  
From personal experience in the region Chinese influence, especially in Cambodia and Vietnam to a smaller degree, became evident after seeing how ethnic Chinese dominated business.

The engagement in Africa has been met with much more public scrutiny. Having been dubbed “The new colonialists” China is proceeding with more caution.
Since China needs natural resources in order to continue growing she has been dealing with countries and under circumstances Western nations nowadays prefer not to accept. 
How their behaviour changes once North Sea oil is depleted and Mexico curbs oil exports is anyone’s guess. China imports a third of its crude oil from Africa and some minerals.  

However as noted above, on a per-capita basis China’s foreign exchange reserves aren’t that impressive and there is a focus to concentrate on solving the vast array of problems at home. Nonetheless China is engaging in the world at a rising speed and has found its influence already increased. 


Graph from blogs.cfr.org/setser/2009/05/24/the-almo.../

Much to the chagrin of many Europeans who were hoping to make themselves finally heard after the financial crisis gave credence to their claims about the perils of the Anglo-Saxon economic model and need for stronger regulation (and enforcement of that regulation) they were left at the back seat when during the G20 meeting in London all the talk had been about the “G2” of America and China. All of a sudden China had arrived at the table seemingly without much care for Europe’s demand for a multipolar world. Europe suffered from being divided into several camps; Britain which has been an advocate of the American model and followed with quantitative easing, Germany which demanded tighter regulation, oversight bodies and a strong currency and PIIGS who dealing with the first crisis since joining the Euro were no longer able to devalue their currency or inject liquidity. Adding insult to injury they had little room to increase fiscal policy as their credit-worthiness was questioned by rising credit default swap (CDS) prices. 

Britain is facing the loss of its much coveted AAA rating. Alistair Darling’s budget shocked the public with a deficit for 2009 alone that is close to 12% of GDP.  
It is assumed in the budget that over the next five years £700 billion will be borrowed pushing the GDP/Debt ratio to 80%, by 2014 Britain would then be paying £58 billion on interest, that is more than on schools. To put that into perspective China is already earning more than US$ 50 billion per year on interest from the United States. 
The Chancellor of the Exchequer also found himself under massive media scrutiny for having been much too optimistic in previous forecasts and still being too optimistic in his forecasts which is why his figures still have to be taken with a pinch of salt. Jim Rogers, who along with George Soros ran the Quantum Fund, infuriated Gordon Brown by publically calling the UK bankrupt since North Sea Oil is about to deplete and London’s City has suffered from the financial crisis. 
The next prime minister to step into Downing street will have to take some austerity measures, cut the budget and raise taxes if he is to regain the confidence of the bond market, the IMF has already urged Britain to do so. 
However a closer look at the figures reveals that there is little wiggle room, it could very well lead to Britain’s facing a democratic crisis now that politicians have to make cuts but lost credibility after the Daily Telegraph uncovered the so-called ‘expenses-scandal’. Economically the situation is clear, the deficit is not sustainable unless a new source pops up from somewhere. Politically it will be very hard to push these measures through at a time of loss confidence in the political system.
For China this could have the added effect of seeing the legitimacy of the Chinese Communist Party rise. If Britain is unable to deal with this situation properly the Communist Party will find itself strengthened in its emphasis on providing political stability which would set the democratic movement back for decades. 

Judging by the figures there already is a structural deficit and it is hard to see where substantial cuts may come from, raising taxes during a recession is not an option.


Big Tickets 

Social Protection 189bn
Health 119bn
Education 88bn
Defence 38bn
Public security 35bn
Debt 28bn
These Six alone 477bn





Footing the Bill


Income Tax 141bn
Natural Insurance 98bn
VAT 68bn 
Corporation tax 35bn







Without taking into account any additional burden for welfare or a possible more adverse scenario where tax receipts fall Britain already finds itself in a situation where its six core obligations are only just met by its revenue. 


During the boom years after the collapse of the ‘New Economy’ Britain’s coffers were swelled by windfall taxes from financial companies and their employees as well as a rising housing market which blew a bubble even larger than the American one. 


Eurozone

As can be seen on the graph above Britain was not alone in seeing massively rising house prices, in fact Ireland was atop with Spain slightly under Britain but still above the United States. Spain became the eight-largest economy and was celebrating the fact that its economy had seemingly overtaken Italy’s in per-capita terms. Ireland was lauded ‘Celtic Tiger’ for achieving spectacular growth rates but now finds itself in a position where people are speculating that the only thing that saved Ireland from turning into Iceland was being in the Eurozone. 
Ireland’s budget deficit is at around 10% for 2009 , should the world recession continue for longer Ireland could be losing 15% of its economic output. 
Spain managed to rack up five million immigrants during the construction boom and now has an official unemployment rate of 17.4% and rising . The Spanish government is now paying immigrants on average US$ 14,000 but in the first two months only 1400 immigrants decided to take the money and leave.  
How Spain will resolve this situation is not at all clear, especially given their budget deficit is estimated at 6.2%. France’s deficit looks set to be around 7% in 2009 and 2010. Germany’s 3.9% in 2009 and close to 6% in 2010. 
When looking at the situation in those countries it is critically important to remember what was said above, GDP numbers do not take into account how economic activity was achieved. In the case of Spain, Ireland, Britain an asset-fuelled bubble led to wasteful investments and vast overconsumption which becomes apparent when credit growth is compared with economic growth. 
GDP figures are further being affected by government spending, with record deficits and massive ‘stimulus-spending’ the headline figure can’t really account for the massive drop in the productive core sector of the economy.
We are in unchartered territory and with the private sector having offloaded some of its bad debt onto the governments balance sheet the situation really is delicate at best in some European nations. Britain is not alone in that it doesn’t know where to cut and where to raise.
The ‘Axis of Upheaval’ may be closer to home than many may wish to contemplate.

As long as China stays stable politically they will be able to go on about their business in an undisturbed way. At this moment European nations will not be able to speak with a single voice. Europeans countries will most likely decide to cut back on military spending and seek to increase exports. 
China, always a tempting market with its large population and foreign exchange reserves, has already sent out trade delegations to Europe which tied up multi-billion dollar deals. As Europeans seek to balance budgets and appease China for trade deals they will refrain from taking provoking action. 
American policymakers cannot count on European support should they decide to act more confrontational. Furthermore they face the same budget constraints Britain does, if not more so since their deficits are much larger in absolute terms.
At the beginning of this decade China has a window of opportunity where its rivals are weakened by domestic problems while it is high in demand as many nations look to China to pull them out of the recession. With China’s rising economic clout people will be more aware of its behaviour in the diplomatic arena.
Australians are reflecting on the status of their alliance with America as their economy is increasingly linked with China. On the one hand they are joyous about the prospects a rising China brings, on the other hand they are unsure about what to make of expanding military spending. While a closer Sino-Australian relationship is a frightening prospect for America it only exemplifies the lack of power Europeans enjoy in Asia. 
China will increasingly be able to side-step Europe and work with America directly as the “G2”.


Graph on Housing Market: andrewsullivan.theatlantic.com/the_daily...